ECB set for last easy rate cut as trade fuels inflation discord

Irish Examiner

2 days ago

The European Central Bank is set to lower interest rates for the final time on Thursday, before an increasingly complicated inflation outlook risks bringing internal divisions to the fore.
As price risks recede, officials have cut seven times in the last year with little friction on the 26-strong Governing Council. An eighth move is expected this week, bringing the deposit rate to 2%.
But while some would like that to be the bottom — wary of a glut of spending to come by European governments — others want more to underpin flimsy economic growth.
The key sticking point is Donald Trump's tariffs — specifically, their knock-on effects for eurozone prices. The ECB is mapping out various scenarios to try to better grasp what is coming, but confidence in any given outcome is in short supply. One policymaker puts the chances of the baseline materialising at less than 50%.
The upshot is the ECB is shifting away from tackling elevated inflation to a phase characterised by the kind of unpredictability seen during covid and Russia's war in Ukraine. That means it must be attuned to the risk of price gains coming in either side of 2%, according to Katharine Neiss, chief European economist at PGIM Fixed Income.
'It's very possible that the macro picture warrants near-term cuts to support the economy through this period of uncertainty, but that higher rates are needed further out, assuming other policy levers such as fiscal come into play,' she said.
That said, it will be important for the ECB to remain alive to the risk of returning to too-low inflation, as was the case in the decade before 2020.
With price growth nearing the 2% goal, investors still reckon there will be one more decrease in rates after this week, but are not sure when. Analysts in a Bloomberg poll are more certain — predicting moves in June and September for a terminal rate of 1.75%.
Trump's actions on trade could yet upend those views. While most European Union goods are currently subject to a 10% US levy, that could jump to 50% in July. The ECB's scenario analysis, due as part of its quarterly outlook, underscores the uncertainty.
As things stand, the near-term inflation picture looks benign: Energy costs have cratered and the euro has strengthened since the US first unveiled 'reciprocal tariffs' in April. Eurostat figures for May will arrive on Tuesday, likely showing an on-target reading of 2%.
But how prices evolve will hinge on possible retaliation from Brussels and how the US-China relationship pans out. In the longer term, European spending on defence and infrastructure, fractured supply chains and an aging workforce could feed inflation pressure.
Against this backdrop, hawkish executive board member Isabel Schnabel has cautioned against more easing, arguing the ECB is 'in a good place to evaluate the likely future evolution of the economy' and act as needed.
Dutch central-bank chief Klaas Knot and Bundesbank president Joachim Nagel have also warned the medium-term inflation outlook is murky.
For Holger Schmieding, chief economist at Berenberg, the future will be dominated by upside threats to prices.
'The main reasons are demographics and the structural labour shortage,' he said.
At the moment, much is overshadowed by Trump's policies. But monetary policy is already working, and there's no need to add significantly more stimulus now.
Some Governing Council members are open to more forceful action. Belgium's Pierre Wunsch has said the ECB may need to support the economy 'a little bit' to ensure inflation does not fall below target. Lithuania's Gediminas Simkus said there were increasing risks of an undershoot on prices.
Should the outlook start to point in that direction, it is not clear what the optimal strategy would be. While some may back more rate reductions to guard against price expectations falling too low, others would probably opt for Schnabel's 'steady-hand' approach.
Investors may not get a lot more guidance from ECB president Christine Lagarde on Thursday. Rather than hinting what may happen, the ECB has recently preferred to highlight the factors on which its decisions will be based.
'There are massive uncertainties littering the road ahead and the ECB will take great care not to pre-commit itself during the next press conference,' said Sonja Marten, head of currency and monetary-policy research at DZ Bank. She sees two more cuts this year, with little reason to turn stimulative because growth should look rosier again in 2026.
Some analysts expect more easing. AXA Group chief economist Gilles Moec said the continued headwinds from the US and the danger of Chinese goods being diverted to Europe point to softer inflation and rates dropping as low as 1.25% — even if policymakers will find it difficult to get there.
'Every single cut from now on is going to be much tougher,' he said. 'There'll be growing resistance, so it'll come down to the data to convince the Governing Council to go as far as I think they'll have to end up going. It'll make for complicated conversations after the summer.'
Bloomberg
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